How to Trade CFDs – Everything You Need to Know
Learning how to trade CFDs is exciting, but it’s normal to be a little apprehensive too. Contracts for Difference are risky and complicated instruments. Master trading them, however, and you gain hundreds of opportunities to profit. With this guide, you can learn everything you need to know to enter the CFD market safely. We’ll cover:
- What exactly Contracts for Difference are
- How you can use leverage with CFDs
- The 4 key CFD trading conditions
- 6 simple steps to get started with CFD trading
What are CFDs?
Contracts for Difference (CFDs) offer traders the chance to profit from market price movements, without needing to own any assets outright. A CFD is a contract between a trader and a broker to exchange the difference in the value of a financial asset, between the time the contract opens and closes.
We know that sounds complicated, so let’s break it down.
- You think gold is going to increase in value today. You don’t know where you can go to buy gold bars, and you don’t want to deal with having to store them somewhere.
- Instead, you log on to your online broker and purchase 100 CFDs on gold.
- In doing this, you are telling the broker you think gold will appreciate in value.
- If gold increases in value, you can close your trades and make a profit.
- If gold decreases in value, you close your trades and lose your initial investment.
CFDs are completely safe trading instruments, so long as you know how to use them properly and you opt for a regulated broker. They can, however, be riskier than stocks or commodities, as you have the chance of losing your complete investment.
The Different Types of CFDs
When learning how to trade CFDs, it’s important to know they are derivative products. This means they derive their value from the underlying asset, but you never actually own it. Because of their characteristics, you can trade over 20,000 different CFDs in multiple asset classes. This includes:
- Stocks – Contracts on shares from companies like Apple, Amazon, and Microsoft
- Precious Metals – Contracts on gold, silver, and platinum
- Commodities – Contracts on hard commodities, like crude oil, or soft commodities such as corn and cocoa
- Indices – Contracts on major world indices like The S&P 500, NASDAQ, or NIKKEI
- ETFs – Contracts for trading exchange traded funds, such as the SDPR Trust or the PowerShares QQQ Trust Series
It can be a little confusing when a broker offers both direct investment opportunities and Contracts for Difference on the same assets.
For example, a broker may allow you to trade Apple shares directly and CFDs on Apple shares. When you trade Apple shares, you own the share until you sell it again. With a CFD on an Apple share, you only have a contract that depends on the price shifts of that share.
The benefit of trading CFDs rather than assets is that you can go long or short and can use leverage. Don’t know what these terms mean? Read on, we’ve got you covered.
Long and Short CFD Trading Explained
CFD trading allows you to speculate on price movements in either direction. This means that you can profit even when the price of an asset is falling. You can’t do this with traditional trading.
When learning how to trade CFDs, you’ll often come across the terms ‘going long’ or ‘going short’. Let’s discuss what each means:
- When you ‘go long’ with a CFD, you speculate that the price of the underlying asset will increase. If this happens, you secure a profit.
- When you ‘go short’, you believe the price of the underlying asset will drop. If it does, you generate a profit.
For example, if you believe Microsoft is about to have a bad day, you could ‘go short’ with a share CFD. You open the Contract for Difference at one price, wait for it to drop, and close your trade when Microsoft shares are worth less. You gain the difference between the opening price and the closing price as profit.
How Leverage and Margin Work with CFDs
To learn how to trade CFDs successfully, you must understand the benefits of leverage trading. Leverage is credit from your broker that helps you increase trading capital and gain more profits. Brokers express leverage limits as ratios, and you can trade CFDs with leverage of up to 1:100.
Imagine you want to trade $50,000 worth of stocks. With a standard trade, you must pay the full amount upfront. With a contract for difference and leverage of 1:100, you only need to deposit 1%. This means you can open that position with just $500.
Leverage can make your money go further, yet it’s important to realize the broker still calculates your profits and losses on the full size of your position. If you were to lose a 1:100 leveraged trade, you’d lose 100x more money than you initially deposited. It’s important, therefore, to only trade with leverage ratios you can afford. For beginners learning how to trade CFDs, we recommend never trading with a leverage ratio higher than 1:20.
To understand leverage better, you must understand margin too. Going back to our example, 1:100 leverage implies that for a $50,000 position, you need to provide $500. This is your deposit margin amount.
If it looks like you may incur losses greater than the deposit margin amount, and your available account balance, your broker will request a maintenance margin amount. This amount allows you to keep your trade open until it becomes profitable again. If you don’t provide this amount, the broker closes your position, and you’re stuck with your losses.
The 4 CFD Trading Conditions You Need to Know
Now you know what CFDs are, you can learn more about how to trade them. There are four main key conditions behind trading CFDs; spreads, deal size, duration, and profit/loss. Below, our experts explain each one to prepare you for entering the market.
Spreads and Commissions on CFDs
When you trade CFDs, the broker will offer you two prices:
- The bid price is the price at which you can open a short position. It represents how much the broker will pay to buy the underlying asset.
- The offer price is the price at which you can open a long position. It represents how much the broker will sell the underlying asset for.
Bid prices are always slightly lower than the real market price, and offer prices are always slightly higher. We call the difference between these two prices the spread. The spread is the fee you need to pay to open the position.
Whilst spreads are the most common CFD trading fees, your broker may charge commissions instead. This is usually the case if you are trading stock CFDs, as this is how they charge for traditional stock trades top. Brokers may express CFD commissions as fixed amounts (e.g. $3 per trade), or as percentages.
When you trade CFDs, you do so in lots. A lot is a standardized quantity of the underlying asset. Lot sizes vary depending on what you want to trade:
- For forex CFDs, a standard lot is equal to 100,000 currency units
- For gold CFDs, a standard lot is equal to 100 troy ounces.
- For stocks CFDs, a standard lot is equal to 100 shares
Many brokers will allow you to trade fractions of a standard lot. This is perfect if you have a restricted budget. A mini lot is equal to 1/10 of a standard lot (0.1), and a micro lot is equal to 1/100 of a standard lot (0.01).
If you wanted to use CFDs to speculate on the price of an individual company share, therefore, you could use a micro lot.
Stock CFD standard lot = 100 shares
100 ÷ 100 = 1
Stock CFD Micro Lot = 1 share
Understanding lots is a very important step in learning how to trade CFDs, as it allows you to make more informed calculations, knowing what the exact size of your position is.
Although many traders liken CFD trading to option trading, CFDs do not have a fixed expiry date or time. You can hold a CFD position as long as you like. However, this doesn’t mean you should do this often.
If you keep a CFD position open for longer than a day, your broker will charge you an overnight fee. Known as a swap fee, this cost reflects the interest on any capital the broker lends you to perform the trade. If you compound trading days and turn them into weeks, therefore, overnight fees become quite expensive.
Profit and Loss
When the time comes to calculate your profits or, unfortunately, your losses, there is a simple formula to use. First, you need to multiply the deal size (total number of contracts) by the value of each contract. Then, you need to multiply this figure by the price difference between the closing price and the opening price of your position.
(Deal Size x Value of Each Contract) x The Difference Between Opening and Closing Prices
Let’s say you open 10 CFD contracts with a value of $1,000 each. Your total position size is $10,000. The opening price on this trade was 1.3242 and the closing price was 1.3249, making the difference between these prices 0.0007, i.e. 7 pips. Multiply 10,000 x 0.0007, and you have your profit, $7.
How to Trade CFDs in Six Simple Steps
Once you’ve got to grips with what to expect from CFD trades, it’s time to put your knowledge into practice. If you’re trading for the first time, follow our step-by-step guide with a demo account. A demo account provides a virtual trading platform that simulates all market developments, yet you don’t need to risk real money in it.
When you’re finally ready, make a deposit and repeat the steps!
1. Choose a CFD Broker
The first thing you need to do is to find a trustworthy CFD brokerage. Trading with a broker that puts your financial security first, instead of their profits, ensures that you can enjoy learning how to trade CFDs without worrying.
To find the best CFD broker for you, spend some time doing your research. You want a broker that offers a top-tier license (from the likes of the CySEC, FCA, or ASIC) and competitive spreads. You should also look for those that provide a wide variety of CFD instruments, so you can diversify your trades, and excellent trading platforms such as MetaTrader 4 and 5.
2. Identify a Trading Opportunity
As a beginner trader, finding your very first trading opportunity can feel daunting. Luckily, most reputable CFD brokers arm you with an assortment of trading tools to help you find a trade that’s right for you. These include:
- Charting tools help you track trends in the market.
- Technical indicators allow you to pinpoint exactly when prices are deviating from the trend lines.
- News notifications alert you to breaking events that have the potential to move markets.
- Economic calendars enable you to plan your trades around important data releases.
- Sentiment tools show you whether other traders are taking long or short positions.
- Trading signals are actionable ‘buy’ and ‘sell’ ideas sent straight to your desktop or mobile device.
3. Choose Your Trading Conditions
The next step is to determine the exact conditions of your trade. First off, you need to decide whether you want to go long or short. To do this, you must conduct an analysis using the tools listed above. If you think the price of the underlying asset is likely to increase, then you should go long (buy). If you think it will decrease, take a short position (sell).
You also need to decide the number of contracts you want to trade. This will depend on your budget and the price of each contract, as some are more expensive than others. If you are a beginner CFD trader, we recommend only opening a few contracts at a time, as this reduces your risk. Once you get a better hold of the way the market works, you can increase that number gradually.
4. Decide Which Order Type is Best for You
Once you’ve decided how much you want to trade, you need to decide how you want to trade CFDs too. There are different order types you can place in the market, each with its own qualities.
The two most common order types are market orders and pending orders. With the market order, you’re placing your trade immediately. With a pending order, you can specify the price point at which you want the trade to open in the future.
To help limit your potential losses, add a ‘stop’. Stops automatically close your trades when the market moves against you. There are several stop orders, including:
- Standard Stop-Loss Orders – With this stop order, you can specify at which price you want to close your positions. The broker will then attempt to close your positions as close to that price as possible. Unfortunately, market volatility may make this impossible.
- Guaranteed Stop-Loss Orders – The guaranteed stop-loss order also closes your positions at a specific point. Unlike standard stop-loss orders, however, the broker guarantees that your trades will be closed, regardless of market volatility.
- Trailing Stop-Loss Orders – The trailing stop-loss order is a more advanced version of a stop-loss. Not only does it save you from big losses by closing out a position at a specified point, but it readjusts itself from time to time. If the market moves in your favor, the stop-loss will move with it, to protect your profits. If the market moves against you, however, the stop-loss locks in to minimize your losses.
5. Place Your First Trade
Now you know which CFDs you want to trade, how much you want to trade, and what order type you want to place, it’s time to place your first trade.
To do this, open up your trading platform. Enter all the details you decided on in the previous steps (CFD instrument, trade size, order type) and click buy or sell. It’s that easy.
6. Monitor and Close Your Positions
Even though you’ve taken all the measures to secure your trading position, your involvement in the process isn’t over yet. You still need to monitor price fluctuations so you can change or close your trades when the time is right
Keep in mind that your profit and loss levels will fluctuate multiple times as prices rise and fall. Don’t close out at the first sign of profit/loss. Instead, observe the chart and keep your preferred outcome or maximum loss in mind.
Once the chart reaches these amounts, close your positions. To do this, you can simply click ‘close’ within the trading platform. If you want to continue trading, you can also close your position by placing the same trade you originally placed, but in the opposite direction.
CFD Trading Example – Buying a Stock CFD
At first, learning how to trade CFDs can seem more complicated than trading traditional instruments like forex or stocks. To make it easier to understand, our experts created the following example to guide you through opening and closing a trade.
Let’s say you want to trade Apple Share CFDs (AAPL). You check the trading platform, and it currently has a bid price of $118.65 and an offer price of $118.70.
You know the new iPhone is coming out today, so you think the share price will rise. You decide to buy 100 share CFDs at $118.70 each. The total trade size, therefore, is 118.70 x 100. This equals $11,870.
Because your Apple CFDs are a leveraged product, you needn’t deposit $11,870. Instead, let’s assume your broker has a 1% margin requirement, i.e. 1:100 leverage. This means that the $11,870 position will only require a deposit of $118.70.
Once you place your position, there will be two outcomes:
- If the prediction is correct and the price of Apple shares increases, your CFD position will generate a profit for you.
- If the prediction is wrong and the Apple share price drops, you’ll lose money.
If Your Prediction is Correct
The new iPhone comes out and you were right – Apple’s share price is rising. You decide when to close your position when the price reaches $121.70. To calculate your profits, you first need to work out the difference between the closing and the opening price of your position:
$121.70 – $118.70 = $3
You then need to multiply the difference by the size of your position (the number of contracts you opened):
$3 x 100 = $300
This is your profit. Remember, however, that you must also subtract any trading fees from this amount.
If Your Prediction is Incorrect
Unfortunately, Apple delays the release of the iPhone. This is unusual and people worry about the company. Apple’s share price drops. You decide to avoid further risks and close your position as the price falls to $115.70.
The difference between the opening and closing price is $2, meaning you made a loss of $200 ($2 x 100).
Although you only paid $118.70 to open the trade, you will now need to pay for the loss in full, plus any trading fees. This is why leverage can be both beneficial and dangerous.
Top CFD Trading Tips from Our Experts
Having traded CFDs for years, our experts have come up with multiple useful tips that can drastically improve your trading experience in the market. Here is a couple of them:
- Control Your Leverage – As you can see from the examples above, leverage is a double-edged sword. Always be careful when choosing your leverage rate – bigger isn’t always better, and you shouldn’t feel you must use all the leverage a broker offers.
- Keep Track of Your Trades – As your learning how to trade CFDs, write a trading journal. Document which instruments you traded, your entry and exit posits, your trade sizes, and so on. Tracking your progress will help you identify your mistakes and your successes. Reviewing your journal often will also allow you to make smarter and faster decisions in the future.
Advanced CFD Trading Strategies
Once you’ve learned the basics of how to trade CFDs, you can then move on to more advanced strategies to boost your trading profitability. Here are a couple of popular strategies:
- Breakout – You can use a breakout strategy when the CFD price goes beyond the support and resistance level and forms a new trend.
- Contrarian – Contrarian traders place positions against the CFDs that are currently in a limelight. They believe that once the spotlight dissipates, their price will change and go in favor of their contrarian position.